REITs May Be Benched, Despite Valuation

By Dimitra DeFotis

Real Estate Investment Trusts are like New England Patriots quarterback Tom Brady: they need to be benched at least until their offense proves itself once again.

So says Jeff Middleswart, a senior analyst at Ranger International Management. REITs may look undervalued after underperforming the broader market. But Middleswart writes today that he’d put more chips on football’s Brady than on REITs. After beating the market at the start of the year, REITs started to move lower as bond yields began their sharp ascent in May. Equity REITs lost 17.3% from their May peak through August 30.

Since 2004, with the exception of 2007, 2008 and 2012, REITs have outperformed the market. They’ve been a good investment. But yields have moved lower. Middleswart writes:

“By April 30 of this year the median dividend yield of the top 20 REITs was just 3.2%. That is hardly generous for an investment with a history of delivering more in the way of income than growth of income. The difference between REIT yields and the yield on the S&P 500 also narrowed. … The requirement that REITs distribute 90% of all income generated further differentiates them from the typical equity. However, asset classes are typically included in a portfolio for their diversification attributes. We find it interesting that over the last two years (despite the recent sell-off) the FTSE NAREIT Index has a correlation coefficient vs. the S&P 500 of .81. That’s compared to a figure of .65 for utilities as measured by the Philadelphia Utility index, and .59 for the Alerian MLP index. Investors looking to invest in loosely correlated assets may want to think twice about a significant allocation to REITs. Despite their strong correlation with stocks, REITs have been behaving more like bonds than stocks since rates began rising. … Unfortunately, REITs have a history of delivering meager dividend growth.”

Middleswart’s caveat: “We do have domestic and international REIT exposure in special situations where operations are improving, leverage is modest and dividends appear solid with good prospects for growth.”

After Fed taper worries took a toll on some closed-end real estate funds, Morningstar earlier this month noted that you have to read the fine print. Cohen & Steers Quality Income Realty (RQI) does not typically generate enough net investment income to cover its distribution and has realized substantial capital gains. Closed-end funds employ leverage, unlike exchange-traded funds like the Vanguard REIT Index ETF (VNQ). More on our funds blog here.